2016

By Lamont Black, Ioannis Floros and Rajdeep Sengupta (RWP 16-05, June 2016)
We study bank equity issuance during 2001–14 by publicly traded U.S. banks through seasoned equity offerings (SEOs), private investment in public equity (PIPEs), and the Troubled Asset Relief Program (TARP). Our results show that private investors were an active and important source of bank recapitalization in the United States as issuance through SEOs and PIPEs peaked in the recent crisis. We find that bank characteristics predict which firms are likely to issue equity, whereas trading indicators predict issuance type. Specifically, we find large banks with illiquid but better quality assets were more likely to issue equity during the crisis, and investors almost always issued equity to well-capitalized banks. In addition, we find banks with lower trading activity and wider spreads were more likely to issue equity under TARP than to private investors. These results indicate that banks with less transparent assets—assets that are harder to value—are less likely to issue equity to private investors. Our findings suggest, however, that once banks issue equity under TARP, they are more likely to issue to private investors in the future. Indeed, in some cases, banks issued equity to private investors to repurchase equity under TARP.

2015

By Geetesh Bhardwaj and Rajdeep Sengupta (RWP 15-02, February 2015)
A metric of credit score performance is developed to study the usage and performance of credit scoring in the loan origination process. We examine the performance of origination FICO scores as measures of ex ante borrower creditworthiness using loan-level data on ex post performance of subprime mortgages. Parametric and nonparametric estimates of credit score performance reveal different trends, especially on originations with low credit scores. The data suggest a trend of increased emphasis on higher credit scores accompanying a trend of increased riskiness in other origination attributes. Over time, this increased emphasis on credit scoring coincided with deterioration in FICO performance largely due to the fact that higher credit score originations of later cohorts were more likely to have riskier attributes. However, controlling for other attributes on originations and changes in economic conditions, we find that, as measures of borrower ranking, FICO performance on subprime loans over the years remains fairly stable.

2014

By Michal Kowalik (RWP 14-18, December 2014)This paper studies banks' decision whether to borrow from the interbank market or to sell assets in order to cover liquidity shortage in presence of credit risk. The following trade-off arises. On the one hand, tradable assets decrease the cost of liquidity management. On the other hand, uncertainty about credit risk of tradable assets might spread from the secondary market to the interbank market, lead to liquidity shortages and socially inefficient bank failures. The paper shows that liquidity injections and liquidity requirements are effective in eliminating liquidity shortages and the asset purchases are not. The paper explains how collapse of markets for securitized assets contributed to the distress of the interbank markets in August 2007. The paper argues also why the interbank markets during the 2007-2009 crisis did not freeze despite uncertainty about banks' quality.

2013

By Nada Mora (RWP 13-06, June 2013; Revised December 2014)This paper reconciles industry conditions with the state of the economy in driving asset liquidation values and, therefore, recovery rates on defaulted debt securities. Macroeconomic effects matter but they operate differentially at the industry level. I find that industries whose sales growth is more correlated with GDP growth recover less during recessions. And industries that are more dependent on external finance recover more when the stock market rises. Direct measures of industry distress and industry fundamental value, in addition to measures of bond market illiquidity, enter with reduced economic and statistical significance once the constraint that the macroeconomy should have a uniform effect is relaxed. The results of this paper are not incompatible with the industry-equilibrium view put forward by Shleifer and Vishny (1992) and others, but it unmasks a channel of transmission from the macroeconomy.

2011

By Michal Kowalik (RWP 11-02 March 2011; Revised October 2012)The paper derives optimal capital requirements, when the bank’s quality is private information. The supervisor can inspect the bank and punish the undercapitalized one with recapitalization and downsizing. The cost of bank’s capital and its ability to sell its assets are crucial for the bank’s incentive to reveal its quality truthfully. The paper provides following policy implications. First, sensitivity of capital requirements to the bank’s quality should be low in good times and high in bad times. Second, a leverage ratio should be accompanied by a requirement that the bank selling its assets retains part of them. Third, using results from supervisory inspection on the secondary market for the bank’s assets increases the bank’s incentive to misreport its quality. Fourth, implementation of the sensitive capital requirements cannot rely solely on information revealed on the market for the bank’s assets.

2010

By Michal Kowalik and David Martinez-Miera (RWP10-11 April 2010)
This paper analyzes the role of expected income in entrepreneurial borrowing. We claim that poorer individuals are safer borrowers because they place more value on the relationship with the bank. We study the dynamics of a monopolistic bank granting loans and taking deposits from overlapping generations of entrepreneurs with different levels of expected income. Matching the evidence of the Grameen Bank we show that a bank will focus on individuals with lower expected income, and will not disburse dividends until it reaches all the potential borrowers. We find empirical support for our theoretical results using data from a household survey from Bangladesh. We show that various measures of expected income are positively and signficantly correlated with default probabilities.

By Nada Mora (RWP10-12 September 2010; Revised February 2013)This paper tests for agency problems between the lead arranger and syndicate participants in the syndicated loan market. One problem comes from adverse selection, whereby the lead arranger has a private informational advantage over participants. A second problem comes from moral hazard, whereby the lead arranger puts less effort in monitoring when it retains a smaller loan portion. Applying an instrumental variables strategy, I find that borrowers' performance is influenced by the lead's share. Dynamic tests extract active contributions made by the lead, supporting a monitoring interpretation. Loan covenants serve as a mechanism to induce the lead arranger to monitor.

By Robert DeYoung, Emma Y. Peng and Meng Yan (RWP10-02 January 2010)
This study examines whether and how the terms of CEO compensation contracts at large commercial banks between 1994 and 2006 influenced, or were influenced by, the risky business policy decisions made by these firms. We find strong evidence that bank CEOs responded to contractual risk-taking incentives by taking more risk; bank boards altered CEO compensation to encourage executives to exploit new growth opportunities; and bank boards set CEO incentives in a manner designed to moderate excessive risk-taking. These relationships are strongest during the second half of our sample, after deregulation and technological change had expanded banks' capacities for risk-taking.

2008

By Allen Berger, Robert DeYoung, Mark Flannery, David Lee and Ozde Oztekin (RWP 08-01 April 2008)
Large banking organizations in the U.S. hold significantly more equity capital than the minimum required by bank regulators. This capital cushion has built up during a period of unusual profitability for the banking system, leading some observers to argue that the capital merely reflects recent profits. Others contend that the banks deliberately choose target capital levels based on their risk exposures and their counterparties? sensitivities to default risk. In either case, the existence of ?excess? capital makes it difficult to observe how banks manage their capital levels, particularly in response to regulatory changes (such as Basel II). We propose several hypotheses to explain this ?excess? capital, and test these hypotheses using annual panel data for large, publicly traded U.S. bank holding companies (BHCs) from 1992 through 2006, and an innovative partial adjustment approach that allows both the target capital ratios and the speed of adjustment toward those targets to vary with firm-specific characteristics. We find evidence to suggest that large BHCs actively managed their capital ratios during our sample period. Our tests suggest that large BHCs choose target capital levels substantially above well-capitalized regulatory minima; that these targets increase with BHC risk but decrease with BHC size; that BHCs adjust toward these targets relatively quickly; and that adjustment speeds are faster for poorly capitalized BHCs, but slower (ceteris paribus) for BHCs under severe regulatory pressure.

2007

By Elijah Brewer III and Julapa Jagtiani (RWP 07-05 July 2007)
This paper examines an important aspect of the “too-big-to-fail” (TBTF) policy employed by regulatory agencies in the United States. How much is it worth to become TBTF? How much has the TBTF status added to bank shareholders’ wealth? Using market and accounting data during the merger boom (1991-2004) when larger banks greatly expanded their size through mergers and acquisitions, we find that banking organizations are willing to pay an added premium for mergers that will put them over the asset sizes that are commonly viewed as the thresholds for being TBTF. We estimate at least $14 billion in added premiums for the nine merger deals that brought the organizations over $100 billion in total assets. These added premiums may reflect that perceived benefits of being TBTF and/or other potential benefits associated with size.

By Elijah Brewer III, William E. Jackson III, and Julapa A. Jagtiani (RWP 07-13 December 2007)
Commercial bank merger and acquisition (M&A) transactions are especially informative for analyzing the impact of differing corporate governance structures on the balance of corporate control between managers and shareholders. We exploit these special characteristics to investigate the balance of control between top-tier managers and shareholders using data from bank M&A transactions over the period 1990-2004. Unlike research on non-financial firms, the impacts of independent directors, managerial share ownership, and independent blockholders on bank merger purchase premiums in this environment are likely to be measured more consistently because of industry operating standards and regulations. It is also the case that research on banks in this area has not received adequate attention. Our model controls for risk characteristics of the target and the acquiring banks, the deal characteristics, and the economic environment. The results are robust. Our results are consistent with those found for non-financial firms, and are consistent with the hypothesis that independent directors could provide an important internal governance mechanism for protecting shareholders’ interests especially in large scale transactions such as mergers and takeovers. We also find results consistent with the conflict of interest argument, where top-tier managers tend to trade potential takeover gains in return for their own personal benefits, such as job security and other employment related perquisites. Our overall findings would support policies that promote independent outside directors on the board of commercial banking firms in order to provide protection for shareholders and investors at large.

By Douglas D. Evanoff, Julapa A. Jagtiani, and Taisuke Nakata (RWP 07-07 September 2007)
Previous studies have found that subordinated debt (sub-debt) markets do differentiate between banks with different risk profiles. This finding satisfies a necessary condition for regulatory proposals which would mandate increased reliance on sub-debt in the bank capital structure to discipline banks’ risk taking. Such proposals, however, have not been implemented, partially because there are still concerns about the quality of the signal generated in current debt markets. We argue that previous studies evaluating the potential usefulness of sub-debt proposals have evaluated spreads in an environment that is very different from the one that will characterize a fully implemented sub-debt program. With a fully implemented program, the market will become deeper, issuance will be more frequent, debt will be viewed as a more viable means to raise capital, bond dealers will be less reluctant to publicly disclose more details on debt transactions, and generally, the market will be more closely followed. As a test to see how the quality of the signal may change, we evaluate the risk-spread relationship, accounting for the enhanced market transparency surrounding new debt issues. Our empirical results indicate a superior risk-spread relationship surrounding the period of new debt issuance due, we posit, to greater liquidity and transparency. Our results overall suggest that the degree of market discipline would likely be enhanced by a mandatory sub-debt program requiring banks to regularly approach the market to issue sub-debt.